Valuing Partial Interests in Trusts and Assessing the Prudent Investor Standard

Abstract

The financial interests of a trust’s beneficiaries are often diametrically opposed and conflict among trust beneficiaries is common. Although applicable law requires that trustees adhere to lofty standards of “good faith” and “fair dealing” they must make tangible, specific decisions, and sometimes under circumstances in which the settlor’s expectations regarding investments and distributions as set forth in the trust document are unclear. Traditional methods for valuing partial interests in trusts offer insufficient guidance to courts in assessing the prudent investor standard, as they often disregard many of the important factors which go into investment decisions — notably, the allocations to different asset classes.In this paper, we develop a valuation methodology based on Monte Carlo Simulation techniques which allows for economically feasible ex ante valuation of partial interests in trusts. The MCS technique is a widely used in modern finance and economics, and is especially useful for valuing partial interests because it can incorporate mortality risk, portfolio asset allocation, varying distributions and the discretionary sale of the trust’s assets to fund distributions. We explain how the MCS method can incorporate a variety of assumptions about the income beneficiary’s mortality and the trustee’s decisions, and show how these factors affect the valuation of partial interests.